Stock Picking – Consistent Earnings Growth

As said in previous posts, finding stocks that will do well over the next day or week is difficult.  Even finding stocks that will do well over the next month or so is difficult.  The reason is that any news that will affect the stock price in the near term is already priced into the shares.  Whether the stock will go up or down is really a matter of luck since the short-term behavior of the stock will be somewhat random (although our minds will always try to find patterns, even if none exist).

In the long-term, however, prices can be predicted (at least the odds can be placed largely in our favor) for stocks that have predictable growth patterns.  Companies that have increased earnings at a sustainable and relatively reliable rate can generally be expected to continue to do so unless something dramatically changes about the way they do business or they run out of room to grow.  Note the important caveats that the growth rate must be reliable and sustainable.  It must be reliable in that earnings grow consistently rather than cycle between really good and really bad.  The rate must be sustainable because extremely large growth rates (say 40% per year) cannot continue more than a few years.  Because stock price growth tends to follow earnings growth — e.g. if a stocks earnings are increasing at 10% per year the average stock price will tend to increase at about 10% per year — if stocks can be found that have consistent earnings growth, it can be expected that the price of these stocks will increase at the same rate.

So why is it that there will be no price differential for events that happen in the near-term, such as earnings surprises, but there will be in the long-term?  It is not because everyone does not have access to the earnings predictions — they are widely available.  It is not that others can’t pick out stocks that have consistent earnings growth — they can, and stocks that have this property tend to command a premium and have P/E ratios that are higher than their peers.  The reason has to do with how stocks are priced relative to other investments, which is based primarily on the projected rate of return and the risk involved.  I’ll cover both aspects in future posts.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Why the Stimulus Bill Won’t Work and How Wealth and Jobs are Created

Today I’d like to take an aside from investment strategy and philosophy and talk about the related topic of how wealth is created and the economy grows.  This is useful to understand to see why the economy is not growing, despite the large amounts of money put into stimulus by the government.

Since the 1930’s when British economist  John Maynard Keynes proposed his theories for economic stimulus, governments have been trying to spur economic growth through government spending.  Keynes reasoned that sometimes, when the private economy was unwilling to spend, the government can cause economic growth by spending more.  The government could buy things and provide work — even if it was just busy work — when the economy was flagging.  This would cause people to start spending money and buying things, which would have a multiplying effect.  For example, since the $10 paid to Sam would be used to buy a sandwich from Jim, who would use it to buy a gallon of gas from Larry, and so on, that $10 paid to Sam would be like $50 or $100.  Once things got rolling and businesses started spending again, the theory said, the government could then scale back their spending, collecting taxes to pay for the moneys borrowed during the slow period.

In order for the economy to truly expand, wealth must be created.  The trouble with Keynesian theory is that wealth is not created; therefore, no real lasting stimulus can result.  To understand why, let’s look at how wealth expands.

Wealth is a measure of the value of things in existence.  The value of things in existence is increased when 1)resources are found and available for use, 2)labor and/or thought is expended to add value to something and make it more useful, or 3)an increase in value is assigned to something by enough people.  The value of things decreases when 1)resources are used up, 2)things which were given value are consumed, or 3)the perceived value of something decreases. 

An example of value creation under the first category is when new oil deposits are found, trees are grown, or land is made available (when America was discovered).  Value is destroyed under category one when resources are used or destroyed, such as when oil is burned or land is reclaimed by the ocean.  Note that value is only created when resources are available for use.  A large pool of oil that no one can get to has little or no value, and it increases or decreases in value as demand for oil increases or decreases.

An example of value creation under category two  would be when a craftsman makes a table, an artist creates a work of art, or a worker takes iron ore and creates pig iron out of it.  Through their labor, people have increased the value of the raw materials, thus adding to the value of things in existence.  An example of using one’s mind to create value is when one devises a new way of using things, such as when silicon chips were invented.  This invention increased the value of silicon (sand), such that silicon deposits suddenly became more valuable.  This type of value is destroyed when the things created become obsolete or are worn out.  Note that performing services, like mowing a lawn, results in no net increase in value because the thing created is destroyed almost instantly, such that wealth is only transferred from the person wanting the service to the person providing it (in the form of money paid for the service).

The third category applies to things such as collector items, fads, and other such things.  Beanie babies became very valuable, such that people were willing to trade labor and materials for them.  This type of value creation tends to be short-lived, however, and is destroyed when people stop assigning the increased value to the items.  Many things in this category eventually lose their value just as Beanie Babies did.

Once wealth is created it can be traded, with currency often being used since money has an implied ability to obtain goods and services.  Money is also a form of wealth, although its value is destroyed if more money is printed.  For example, if a person has $20 and he gets a haircut from a barber, the net result is that $20 is transferred from the customer to the barber.  The customer has a haircut that has value for some time, but in the end the net amount of wealth is fixed at $20.  If a craftsman makes a good quality chair that will last for generations, however, and sells it to the barber for the $20, there is now a new wealth of $40 — $20 in cash and a chair worth $20.  The economy has now expanded.

When the government spends money, no net wealth is created.  This is because the government simply takes money out of the economy, destroys some creating paperwork and holding meetings that are of no lasting value, and then places a lessor amount back into the economy.  To see this, let’s say that John owns a car dealership.  The government taxes John $20,000, spends $2000 in paper work, and then distributes $18,000 to Fred in an effort to spur the economy, who then buys a car from John.  While it is true that John would not have had that car sale to Fred if the government had not given Fred the money to buy the car, the money used to buy the car came out of John’s pocket and some value was destroyed in the process.  If value were actually created, John would be better off simply giving a car to Fred and keeping the extra $2000!

Some stimulus can be created if the government borrows money, since then creation of value in the future is borrowed against to create wealth that can be used today.  The only issue is that because people know the loan will eventually need to be repaid, which will cause a slowdown in the economy, the effect is not as great as it would be if value were actually being created.   Once the government stops borrowing money and starts extracting value from the economy again, the economy will slow and be in the same condition as it was before the deficit spending was done.  In fact, the economy may need to contract to reset itself to equal the amount of wealth actually in existence.

Single Stock Ownership

In some of the funniest radio I’ve heard in a long time, Dave Ramsey (of the Dave Ramsey Show) responded to an emailer’s question, in which the caller asked what she should do with her BP shares, now that they have declined.  He screamed into the radio, to paraphrase, “I don’t buy single stocks, because you never know when the company you buy will dig a hole into the bottom of the ocean and kill everything in the vicinity!!!”

For those who don’t know, Dave Ramsey is the author of a series of books and the host of a popular radio show.  The theme of the show and the books is getting out of debt and generally getting your financial house in order.  Clips can be heard at their website, .   He offers great advice on setting yourself up into a position where you can start investing and growing wealth (by getting rid of all of your debt and spending less than you make so you can invest).

 Mr. Ramsey’s shuns individual stocks.  His  investing style is to buy mutual funds.  Specifically, he spreads his investments over mutual funds in the categories of growth, growth and income, aggressive growth, and international.  He does not buy individual stocks because he believes the risk to be too great.  And as he said, you never know what will happen with any one stock you own.  It may actually drill a hole in the bottom of the ocean.  Or it may just really misread demographics and see earnings implode.

While I do not agree that mutual funds are the only way to go, ownership of only one stock is not advisable, and the number of stocks owned should grow as one’s tolerance for risk declines.  To invest in individual stocks, one must understand their behavior and plan accordingly.  The price of individual stocks changes rapidly, and sometimes for no good reason.  The current price offered reflects people’s feelings about the near-term prospects for the future, what the market is doing, what people expect others to do, where other investments are priced, other events in people’s lives, and recent movements in price.  One cannot buy a stock and expect 10% to be added to their bank account year after year just like a savings account.  Some years it will double, other years it will fall by 50%.  Some years it will move up or down by 2%.  Bad things do happen to good companies as well, and sometimes individual stocks fall rapidly in price, sometimes never to recover.

Because of this, placing large amounts in only one stock or even just a few stocks is foolish.  There were many retirees from GE who watched their life savings implode along with the price of GE stock during the last recession.  If you have large sums of money, you should spread it out over a number of stocks, and even into different sectors and asset categories (stocks, bonds, treasuries, etc…).

For those who do not have a lot of money, however, concentration in a few stocks can be a good thing.  If one is a fairly good stock picker, or even picks one huge winner out of five, one can do very well.  The difference is that if one has a lot of money, the risk of losing a large sum outweighs the potential rewards that can be gained through concentration.  If one only has a small sum to invest, however, it is worth the risk of suffering a loss.  If one only has $1000 and it grows at 10% per year, one would only have $2000 after 7 years.  It is worth the risk of losing the $1000 for the potential to have $10,000 after those same seven years.

Here are the rules I generally use in determining the size of positions:

1.  Never have more in one position then you are willing to lose.  If you cannot afford a loss of $1000, you do not belong in individual stocks.  Very few people (except multi-millionaires) could afford to lose $100,000, so positions that grow so large should be split up into smaller positions.

2.  On the other hand, make sure positions are large enough that if one is right about a stock, one make’s a good profit.  It does no good to be right about a stock that goes from $20 top $40 if one only has $500 invested, since only $500 will be made.  Make sure to take large enough positions so that your winners will result in a large return.

3.  The more money you have, and the shorter your time horizon, the more diversification you should have.  If you have a significant amount of money, or if you do not have much time to recover from a setback, your level of risk should drop.  A person who will retire in five years and plans to live off of his savings should not have his money invested such that a drop in a few stocks would affect his plans.

4.  Have money that is really needed in the next five-ten years in cash.  Again, if you will be retiring soon, there is nothing like having enough to live on for five years in cash.  It was sad to hear of so many putting off retirement because of the recent recession.  These individuals should have been sitting on a pile of cash such that they could care less about the stock market drop.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.